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New products - watch your operational risk management

As a committed operational risk professional, I cannot help but stare in amazement amidst all the financial ruin and desolation that surrounds us. The hand wringing and the weeping about credit risk, liquidity problems, lack of trust and the like are all smoke. And this smoke conceals the true cause, in my view, of all the current problems.  It all points to massive failure in operational risk management, right the way through from where the first cracks appeared last summer in the sub-prime mortgage crisis to the collapse of the investment banks a year later, plus all the panic and pain that has followed.

Now,  before everyone jumps down my throat let me explain.

The Basel II definition of operational risk is "...risk of loss resulting from inadequate or failed internal processes, people and systems or from external events". (Paragraph 644 of the Basel II Accord). Building further on the Basel II theme, not only does the Basel Committee encourage the use of their "Sound Practices for the Management and Supervision of Operational Risk" for the "Basic Indicator Approach", the criteria for both the "Standardised Approach" and the "Advanced Measurement Approaches" are that "at a minimum" (1) the bank's board and senior management must be actively involved in the overseeing it's operational risk management framework, (2) the bank must have an operational risk management system that is sound and (3) that the bank sufficient resources to use this approach in its main business lines plus its control and internal audit areas.

Now let's take a step back to "Sound Practices for the Management and Supervision of Operational Risk" which was published in February 2003. If we look at the section "Risk Management: Identification, Assessment, Monitoring, and Mitigation/Control" we find that it contains three principles. And these three are key to my whole theses. Principle 4 states; "Banks should identify and assess the operational risk inherent in all material products, activities, processes and systems. Banks should also ensure that before new products, activities, processes and systems are introduced or undertaken, the operational risk inherent in them is subject to adequate assessment procedures".

And herein lays the answer to all the current woes that we are afflicted with. If these new weird and wonderful products and processes had been correctly examined we would not be in the predicament we now find ourselves in.

And all this is apart from the initial three principals contained in the document which clearly charge the bank board with developing, maintaining and monitoring the appropriate operational risk management environment.

Unless banks are truly committed to managing operational risk we are going to see this problem repeated, in one guise or another, again and again.


Comments: (1)

A Finextra member
A Finextra member 16 November, 2008, 20:31Be the first to give this comment the thumbs up 0 likes

It looks like some banks thought operational return was the only criteria. I understand there may have been more than one risk professional over-ruled by other department's desires to get new products with fat fees to market.

Perhaps an anonymous survey of risk personnel to see how many 'expressed reservations' that these new packaged products could come back to bite their institution, and were subsequently ignored.

Similarly the rash of refinancing during rate movements generated fabulous fees. In some cases the mortgagees were swapping to another brand backed by the same institution.

It was clear the products weren't adding value in the traditional sense, they merely facilitated off-loading risk and generating added fees. The bail-outs have merely taught banks that they could get away with it.

Perhaps there was a time when banks considered the value a transaction added, and not just to their immediate coffers. We've seen plenty of lip service to environmental ethics in recent FI marketing, however the old-fashioned business ethics were discarded with the old ties.

The 'Plan' governments have put forward mentions having regard for outcomes across borders and the like, but so long as the rules remain disjointed there will problems in a global economy. If uniform rules come out of this crisis we will all be much better off.

None of this gets us out of the current mess.

Some plans have been suggested which perhaps show an opportunity to do so without taxpayers footing the full bill. It's obvious the real estate market will collapse and that depression is inevitable if governments try to use traditional tools, no matter how forcefully or well intended.

Two veteran investment managers, Thomas H. Patrick, co-founder of New Vernon Capital, and Mac Taylor, a principal of the Verum Capital Group have suggested an alternative along the line of my own initial thoughts.

Mr. Patrick told the NY Times.“Our proposal is based upon the fundamental principle that the only way to ameliorate the problem is to somehow improve the underlying collateral. It rewards those homeowners who have paid their mortgages and have demonstrated financial responsibility.”

Their plan is is targeted at the pools of mortgagees at risk of  interest rate resets and issue new loans with fixed interest rates, currently 6.14 percent, and 30-year terms. Under this plan, Fannie Mae and Freddie Mac would issue debt to pay off the outstanding principal on the loans and then guarantee the new ones.

Investors who own the underlying interests in the mortgages would be fully repaid and the securitizations would be closed out.

Provided a complete collapse was averted, taxpayers would be not as bad off as under the current plan and homeowners would stay in their homes.

The Patrick-Taylor plan would provide about $385 billion infusion without a bail-out and would require banks to buy the $400 billion in delinquent securitized loans at full value, and carry whatever losses they incurred. It is likely to be less than under the current plan and  certainly less than the $1.1 trillion in mortgages outstanding.

Governments let the real estate and share dealing con-men run amok.

I have long though that encouraging speculation in ones own home  is both a bad investment and inviting disaster, especially if the interest rate is close to speculative.

I could never escape the economics that although I might enjoy increases in value, the better home I coveted up the street would have increased even more so. Better to invest my money in creating real wealth through adding value and using the profits to buy the better house. I have watched a generation gamble on the roof over their heads with the net result that they just owe more on whatever house they are in, expressed as a percentage of their income.

Spending borrowed money 'jazzing up' one's house merely adds to your pride initially. and then comes the fall when you have to pay it back. Better to invest your money in some enterprise that adds value, and can provide a return without the necessity to make yourself homeless to cash in. Of course that leaves out  google and the other lunatics out there who expect shareholders to be happy without a dividend. The only way you can get a return is to sell your shares? Way to go google contribute to the hot-air overheated market, and your shareholders are forced to time their sales with your hot air blasts which periodically pump up the share price? Didn't they use Her Majesty for the last or was it the "Will Googles Schmidt help out Obama and save the world?" rumour? Let's have the CEO of a one-trick-pony whose company relies on rampant speculation, spying on consumers and citizens and selling their data or providing it to non-democratic despot's and whose shareholders don't even receive dividends?

There's obviously one born every minute. Let's hope Obama isn't one of them.

Risk management is almost impossible in this environment.